[EP 305] Earn-Outs Without the Headaches: Risks, Pitfalls and How to Get Them Right

The Deal Room Podcast 

[305] – Earn-Outs Without the Headaches: Risks, Pitfalls and How to Get Them Right

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Introduction [00:00:00]:

Ladies and gentlemen, good evening. Are you ready?

 

Introduction [00:00:03]:

Okay, here we go. You’re listening to the Deal Room Podcast. Join us as we bring you the inside scoop on business sales and acquisitions. Get across trends in the area and hear the industry’s best recount their real life tips, traps and experiences. Now, here’s your host, Joanna Okey.

 

Joanna Oakey [00:00:25]:

Hi, it’s Joanna Oakey here and welcome back to the Deal Room Podcast, a podcast proudly brought to you by our commercial legal practice, Aspect Legal. Now in this episode we’re sharing some of the insights we covered in our recent exclusive workshop on earnouts.

 

Joanna Oakey [00:00:42]:

This is an area which can be confusing to both brokers and business owners alike and it’s well worth understanding how they work, the risks and the different perspectives involved and, and how each party is likely to deal with an earn out. If you’re interested in insights and workshops.

 

Joanna Oakey [00:01:00]:

Like this, great news.

 

Joanna Oakey [00:01:01]:

We have a library of insights available to business brokers and advisors that we.

 

Joanna Oakey [00:01:07]:

Work with and for clients too.

 

Joanna Oakey [00:01:09]:

And as soon as you begin working.

 

Joanna Oakey [00:01:10]:

With us or referring to us, you’ll unlock access.

 

Joanna Oakey [00:01:14]:

We also have a heap more in store coming up, including AI workshops because things are just moving so fast in this sphere and more hands on training like this. So if you’d like to get in.

 

Joanna Oakey [00:01:25]:

Touch to find out more about getting started, check out the show notes or send us an email [email protected] of course, we’d love to work with you. And now without further ado, let’s get.

 

Joanna Oakey [00:01:39]:

Stuck into earnouts with this episode of.

 

Joanna Oakey [00:01:41]:

The Deal Room podcast.

 

Joanna Oakey [00:01:43]:

So we’re talking about what an earnout is. We’re talking about earnouts versus vendor finance. We’re talking about common mistakes, pitfalls and risks. Some more stories and actually one of the main things I really wanted to talk to you about that’s not in the agenda, but it’s actually going to be. A lot of our discussion is what we do from a legal perspective to control the risk in earnouts. Because I, I just think it’s really one of those areas. It’s super important that you understand what we doing from a legal perspective or the legal wrangling forwards and backwards so that you can help to sort of guide the discussion right at the beginning and to get clarity of the earn out. And I’ll talk a minute about like getting into details about what earnouts are and all of that sort of thing.

 

Joanna Oakey [00:02:31]:

But I just want to preface this by saying one of the things that I think is the greatest potential issue in dealing with earn outs and Earn out, super, super common. You know, we deal with them very regularly. But one of the ongoing issues is ambiguity in the way earnouts are created. What we often have is buyers coming in having heard of the concept of earnout and then putting together this really complicated earn out and I guess sort of brokers feeding that through and ending up with like an earn out that is too complex for the size of the deal that it sits in. And that can create a whole lot of issues, but it can create essentially a risk to the transaction as well. Because when we have this ambiguity when it comes to the point of needing to put this into a contract to get super clear about it to work out, you know, what those parameters are going to be to protect the seller in the earn out, then it can lead to this, the parties sort of realising that they weren’t aligned. And what we really want to do is avoid that from the beginning because we don’t want anyone’s time wasted in this. And you know, I think setting up the right discussions from the beginning can really help make, ensure that we’re driving the right use of earn outs in the right sort of size and type of transaction, if that makes sense for everyone.

 

Joanna Oakey [00:04:03]:

And I’d love some experience shares along the way as to any of the issues that you’re seeing in earnouts and any sort of negotiation issues that you’ve had along the way as well. Okay, so what are earnouts? Earnouts? Well, you probably all know what earnouts are. I, because I know each of you and I’m, I know you, you all understand earnouts. But, but essentially at a high level, earnout’s one of those things that can create a lot of risk and a lot of conflict. And the, the areas where it particularly goes wrong is where the performance targets are ambiguous or the legal protections are missing or weak. So that’s why I want to talk to you about what we do from the legal perspective. Or the buyer has too much control over whether the earn out targets are met or not. So what do we see your role as is brokers.

 

Joanna Oakey [00:05:02]:

Actually we don’t just have brokers in here, we also have account and some other advisors for business. But from a broker perspective, really I think that opportunity for you is to help see the discussion in the structure so that it works not just about getting the number right, if that makes sense. So when we’re Looking at Earnouts vs Vendor Finance here we, I guess from, and I often find that there’s a little bit of confusion essentially earnouts, where we have a deferred payment that is at risk. So it’s like a contingent payment post completion that is based on some performance or milestone metrics. So that performance usually most often is EBITDA or revenue, but it can also sometimes be other metrics. Vendor finance on the other hand is the term that we give to post completion payments. So deferred payments that are fixed. So we’ve agreed, okay, so the buyer and seller have agreed on a price, but that price will be paid, is required to be paid over time no matter what happens in the business, no matter whether there’s performance metrics that have been met or not.

 

Joanna Oakey [00:06:25]:

So there’s no target, no metrics to earn or not to earn the payment. For the seller, you it’s just an agreed amount post completion. And then the third sort of thing or to bear in mind is this concept of retentions and holdbacks. So retentions are holdback. So where part of the purchase price is held back for a particular period of time for a particular reason. So and I find it very interesting because the concept of the terminology of retentions and holdbacks can actually mean a whole heap of different things. So I’ll give you an example. In accounting practise sales, it’s super common for there to be the structure of the sale so that you’ve got 80% paid at completion and 20% or maybe 90% paid at completion.

 

Joanna Oakey [00:07:22]:

But a certain amount held back and then paid when in either 12 months time or 24 months time. The client base has continued with the accounting practise up to a particular level. So that just might be, and there are different ways of setting this out, but it might be. Well the number of clients that were there before completion is still there. So it might be on a client count or it might be on a revenue or it might be. Rarely in an accounting practise is it based on profit or ebitda. Usually it’s on revenue, top line revenue or, or account of clients. But it’s interesting that is actually in all of industries called an earn out, not a retention.

 

Joanna Oakey [00:08:09]:

But in the accounting space we call them retentions, not earn outs. So it’s just sort of essentially the concept being and from the accounting world practise sale perspective it’s about holding back money until to ensure that the assets have transferred. But in other industries the same concept is used but it’s actually seen in a different way.

 

Joanna Oakey [00:08:30]:

It’s.

 

Joanna Oakey [00:08:30]:

It’s that the sale price is dependent on what the performance of the business is post completion. Does that make sense? That sort of difference in the way people think about it. And the problem is people can get caught up with terminology differences, but the, the, the approach to all of this is to not get caught up with terminology differences but just to really understand what is happening in, in the approach of what are the mechanisms for us to meet our targets and what, how are those targets calculated. So what we’re seeing in the market right now, and it’s not even just in the market right now, just generally speaking, earn outs are very common in 2 million plus business or share sale size. The larger the size of the deal, the more likely the earn outs. When we’re in the five plus or five or ten plus million dollar market or we see at least 80 to 90% of our transactions having earnouts as a large component of the deal. And the typical earnouts that we see here in Australia are 10 to 20% of the total sale price. When we have an offshore buyer, sometimes there’s pressure to have that earn out component a lot higher.

 

Joanna Oakey [00:09:52]:

Because in many offshore markets there’s a tendency to a higher sort of at risk component in transactions. The earn out periods usually last in transactions that we see between one to two years, but they can extend up to five years. And I’ve said here, even in rare cases up to seven. Every now and again we’ll get a seven year earn out which is a long, long period of time. Obviously our sellers don’t like that. But the reason a seller might agree to that is, is if actually what they’re getting is a significant upside as a result of the longevity of the earn out period. Okay, so what are our risks in earn out? So I guess three common risks as to why earnouts don’t trigger which may or may not surprise you. The very first thing is that the business doesn’t perform and doesn’t meet the targets.

 

Joanna Oakey [00:10:51]:

So there’s been an issue with the business post completion essentially. And usually this is it can, it’s sometimes as a result of changing market conditions, but sometimes it’s as a result of the fact that the business hasn’t been run in the same way as the sellers run the business or the seller or the businesses had some sort of owner founder dependency. So that hasn’t carried over or been able to carry over. And of course this is exactly the reason why many buyers want earn outs because in many reasons earnouts are there as part of a risk sharing mechanism. And so when the buyer often comes from a perspective of we want to ensure, quite often the buyer is thinking from the perspective we want to ensure that the seller is still is, has a real reason, has skin in the game to make sure the value of this asset in the business or the shares transfers to us properly and that we as a buyer get to see the value of that asset. So, so essentially this is I guess buyer seed is a way to get the seller to assist to make sure that value is transferring. And the second thing is sometimes about ensuring the buyers want to ensure that the value that they thought was there in the business is actually there. So it’s a way of sort of cross checking that the figures and performance of the business are real.

 

Joanna Oakey [00:12:24]:

So it’s not a surprise that the number one reason why you see, and actually I just have to say we don’t see very often sellers not hit their earn out targets. But I have so many discussions in this world of business sell and acquisitions. I know it’s the number one complaint of many sellers who I speak to that they, you know, they feel that in their transaction that you know, and they’ll often carry this, I’ll have these discussions, they’ll carry this issue with them for years and years and years. I sold my best business way back when we had this earn out. I didn’t get it and you know, I’m aggrieved but I started talking to my mates and I worked out no one hits that gets their own outs. So this is a lot of discussion that happens in the market. Anecdotally from my own personal experience from our clients, it actually the our clients. I should go and work out what the percentage is.

 

Joanna Oakey [00:13:23]:

But I’d say at least 80 to 85% of our clients hit their full earn outs and receive their full earn outs. But I think part of that maybe is a mechanism of the way in the deal in which the deals are put together and the way in which obviously the legals protect the seller. But there are some things that we can’t protect and business performance is one of those things that we can’t fully protect against. Of course one of the ways that we, a seller can have some control over business performance is continued involvement in the business post completion. And so we can help achieve that. But if a seller doesn’t want to be part of the business post completion, which happens with some sellers, then and the performance of the business or a decline in the performance of the business really is about market conditions. Of course there’s very little that can be done about that. Okay, so the number two reason is that the earn out targets aren’t hit is just because the sellers have decided to take themselves out before the earnout period has finished.

 

Joanna Oakey [00:14:33]:

And it’s fascinating actually talking to sellers who have gone through that process of essentially running their own show and then ending up in this business where they’re being, I guess, where they’re not making the shots anymore. And in many instances when sellers haven’t hit their earn out targets, haven’t received their earn out payment, it’s because they haven’t stuck around for long enough to ensure that the business hits those targets or they’ve had a connection to the earn out that requires that they stay in the business for the earnout period. And they’ve simply said, look, I’m out of here. I don’t want to do this anymore. I don’t want to work under that, under that buyer. And of course, you know, that’s their decision. I guess for you, you guys as brokers or girls, you people as brokers, the thing that you need to think about is when you’re talking to your sellers about earnouts, I do think it’s important for them to be able to understand what it will feel like for them to be in a business and working for a business. I think we had a hand there.

 

Joanna Oakey [00:15:42]:

So if, if you want to throw, throw a question on the chat, just throw it on there and I’m happy to, or if you want to make a comment, I’m happy to throw the mic to you as well if there’s anything that you know, you have as a response to what I’m saying there. So the number three reason is because buyers change key things in the business that impact the ability of the business to hit the revenue targets or the EBITDA targets or whatever those targets are. And, and of course, this is the key thing or one of the key things that we really trying to protect against from a legal and contractual perspective because it’s this, this element here that the buyer might cause the reason for, for the earn out target not to be hit as the thing that we want to absolutely be thinking really clearly about making sure we have protections in the contractor around. Okay, so war story. So I’ve talked to you about, you know, an example we saw. I talked to you about an interesting case and, and when things make it to court, I think it’s super interesting because it means that there has been so much ambiguity that the parties haven’t been able to settle it. They’ve ended up in court. And in that last case, it was so ambiguous that two levels of court came to a different conclusion.

 

Joanna Oakey [00:17:08]:

So this third sort of Type of example that I want to talk to you about is things that I hear anecdotally. So these are the things that people turn tell me time and time again. So the first one is the Earn Out Survivors club, actually. So I’ve borrowed this phrase from a podcast guest that I had years and years ago and, and she said, you know, she knew she’d sold her business for a great price and she’d had me so many conversations with other founders who’d sold their business and she felt that they were all part of this Earn Out Survivors club where sellers accept earnouts, get into the deal because they think they have to get into the, the post completion period, hate it so much that they just will often leave the business and walk away often from hundreds of thousands, sometimes millions of dollars. So simply because they can’t bear working to the buyer’s tune anymore. And so, you know, they, this podcast guest said that she, she, she and all of her friends that she’d known who’d sold out called themselves the Earn Out Survivors club. Anyone who’d made it through to the end of her earn out and it had actually triggered was a very small percentage in her mind. And she was actually an example and knew loads of examples of founders who just walked away.

 

Joanna Oakey [00:18:33]:

Now of course you say okay, well that’s the seller’s right. If you as a broker have commission tied to that decision, of course that can impact you financially as well. If the structure of what the business looks like and the relationship looks like post completion is that the seller will do whatever they want, even turn their back on money to get out of turning into an employee rather than being the person that runs the business. The second is the perverse outcome approach. And actually I have seen examples of this before, but I’ve heard about a lot as well. But when an earnout causes a depletion in the business value, remember the whole point of an earn out is meant to be so that the value of the business is transferring to the buyer and, and accelerating essentially in the buyer’s hands. But when an earnout causes the depletion in the value of the business, you can see why I’d call it perverse. And in this one example we had a seller and the reason why, Sorry, just to be really clear about the reason why there can be a depletion in the business value is often because the seller is too intimately involved in the business post completion and not allowing the buyer to run the business and in the night in the way they need.

 

Joanna Oakey [00:19:58]:

And this particular example, the seller were in a transaction, the seller was so focused on achieving the earn out that they actually, they completely agree disagreed with the way the buyer was running the business in the earnout period. And they started white anting the buyer to the, to, to the staff and to the clients because, just because they were so frustrated that the business owner they felt was running the business in a way that wasn’t going to allow them to meet their earnouts. And their whole attitude was the thing that actually killed the value in the business and ended up creating the position for them that they, they didn’t hit their earn out targets and didn’t walk away with the earn out payment. So, so we have to be really careful here and I always warn buyers actually to be very careful when they’re setting up the way the earn out works to ensure the earn out doesn’t create perverse outcomes, doesn’t allow the seller to have too much control over the business. But the irony is when we act sell side often we do want control of the business so that we can keep the value there. So you can see there’s this constant tension between buy and sell side in designing earn outs. But I think a great thing for buyers is if they sense that happening in the business just to pay the seller out, get the seller out of the business, let them have their own out so they’re not disrupting the business and go and go and go and run the business on. And then I’ve got one example here.

 

Joanna Oakey [00:21:38]:

Sellers changing office hours, you know, which then has an impact on the amount of custom in the business or changing the level of staffing in a business or also making operational decisions in relation to a business that impact the, the ability of the business to, to hit those earn out targets.

 

Joanna Oakey [00:21:59]:

Well, that’s it for this episode of the Deal Room podcast. We hope you’re now primed for your next deal with these pointers and have enjoyed these fascinating insights. Now, if you’d like more information about This topic, then head over to our.

 

Joanna Oakey [00:22:13]:

Website and go to thedealroompodcast.com where you’ll be able to download a transcript of this episode as well as access any contact details and any other additional information we referred to in today’s podcast. Now, if you’d like to get in contact with our guests today and the services they offer, you can go ahead and check out our show notes for a link right through to them and their details. You can also book in directly with our legal eagles at Aspect Legal. If you’d like to soundboard your next steps discuss a legal question or find out more how we can assist, whether that’s with buying or selling a business.

 

Joanna Oakey [00:22:53]:

Or perhaps somewhere in between.

 

Joanna Oakey [00:22:54]:

Now, don’t forget to subscribe to the Deal Room Podcast on your favourite podcast player to get notifications whenever a new episode is out. We’d also love to hear your feedback, so please leave us a review and rating if you’re already one of our subscribers, or even if you’re listening to this podcast for the very first time, every review helps our team produce valuable content for you.

 

Joanna Oakey [00:23:17]:

Well, thanks again for listening in. You’ve been listening to Joanna Oakey and The Deal Room Podcast, a podcast proudly brought to you by our commercial legal practise. Aspect Legal See you next time, ladies and gentlemen.

 

Joanna Oakey [00:23:31]:

That will conclude this evening’s entertainment. Thanks for listening to the Deal Room Podcast. To find out more about this episode and other episodes in the series, check out the show notes or head over to our [email protected]